TCS to outshine IT peers in 2023, says Motilal Oswal; here are the key reasons

After falling over 26 percent in 2022, the Indian IT sector has been seeing some recovery this year on the back of in-line quarterly earnings, easing recession worries and cheaper valuations. In 2023 so far, the Nifty IT index has advanced 7 percent.

IT major Tata Consultancy Services (TCS) has gained 7 percent this year so far, after falling around 13 percent in 2022. In a recent report, brokerage house Motilal Oswal forecasted that the IT giant will outshine peers in 2023 on the back of its superior cost-focused capabilities to drive performance. The brokerage has a ‘buy’ call on this IT stock with a target price of ₹3,950, implying a potential upside of 18 percent.

"We believe TCS, among our IT services coverage, is best positioned to ride out the near-term moderation in technology spending, on account of macroeconomic stress in developed economies. With tech spending shifting toward cost efficiency (vs focus on transformation over the last two years), TCS revenue growth is expected to outperform its peers (FY24 at 9.2 percent YoY CC in USD vs large cap coverage median of 8.5 percent YoY) on account of its industry leadership in cost optimization and strong order book. Further, its better operational efficiencies are expected to drive up its profitability, leading to 20 percent YoY INR PAT growth in a tough year," explained the brokerage.

RATIONALE

Focus shifting to cost efficiency

Amid the weak macro environment, enterprises are increasing their focus on cost-efficient projects and cutting out some of their discretionary spends, the brokerage pointed out. Commentary across the IT services space suggests caution in discretionary spending and an increased amount of cost optimization mandates in the deal pipeline.

TCS has underperformed its IT services peers over the last two years due to a larger proportion of work focused on short-duration projects with a focus on growth acceleration. As per the brokerage, this trend should reverse in FY24, as cost efficiency capabilities and project execution skills of TCS would drive revenue growth.

MOSL estimates TCS to deliver FY24 dollar constant currency (CC) revenue growth of 9.2 percent YoY, the second best among its largecap coverage (after HCL Tech). TCS has been able to maintain strong traction in deal wins despite weakening macro (1.3x LTMbook to bill), which should support near-term growth. Hence, the brokerage believes TCS is best positioned to deliver a stock return in a constrained demand environment.

Margin pickup to drive earnings growth

The brokerage further highlighted that with easing supply-side pressure and front loading of cost, it expects TCS to improve its EBIT margin by 135 bps over FY23-25 after it declining 170 bps over the previous two years.

"While cost efficiency projects usually command lower pricing, TCS should benefit from the addition of a large pool of freshers (155k over the last 1.5 years, 30 percent of FY21 workforce), improved utilization and strong operating leverage. More importantly, it has best-in-class track record of managing cost efficiency work and strong execution capabilities, which should help the company generate better profitability," highlighted the brokerage. It expects the company to register FY24 and FY25 EBIT margins of 24.8 percent and 25.6 percent, respectively.

It also predicts high single-digit revenue growth and good margin recovery to help TCS deliver an FY23-25 PAT CAGR of 16 percent.

Longer-term demand for IT services intact

Despite the near-term pain, the longer-term demand for IT services remains intact due to weakening macro, the brokerage said.

Firstly, since IT spends are largely non-discretionary in nature, the clients are unlikely to cut spends in case of a macro slowdown apart from some cuts in discretionary spending and secondly, the cloud transformation is a multi-year tailwind and IT services companies should continue to get benefited from the same, the brokerage stated.

Cautions

However, a key concern is that the situation in Europe remains more troublesome compared to the US. The energy crisis is expected to further worsen, noted MOSL. It remains watchful of TCS’s comparatively high exposure to Europe (29 percent), which could negatively impact the revenue.

However, the brokerage pointed out that the UK remains in a better position than Continental Europe. TCS’s decent share from the UK (50 percent of Europe as of 3QFY23) should moderate some of the possible impacts from Europe.

Q3 Earnings

In the December quarter, the IT major reported muted earnings growth as clients tightened spending amid a challenging macroeconomic environment that prompted the country's top IT exporter to reduce its workforce.

For Q3FY23, the company posted an 11 percent year-on-year (YoY) rise in its net profit at ₹10,883 crore vs ₹9,806 in the year-ago period. Consolidated revenue from operations for the quarter came in at ₹58,229 crore, up 19.1 percent YoY from ₹48,885 in the same quarter last year. Though TCS beat the market estimate on revenue which was ₹57,207 crore, the company could not meet the net profit expectation of ₹11,064 crore.

In constant currency (CC) terms, the revenue rose 13.5 percent YoY led by growth in North America and the UK. Its operating margin came in at 25.4 percent, down 0.5 percent YoY.